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ASIA Soaring ore prices may be the silver bullet Beijing needs

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Something strange happened when news broke in Asia of a benchmark iron ore price increase of 65 percent. Shares in regional steelmakers went up as investors, apparently cheering the biggest rise in iron ore costs since 2005, rushed to buy.

The share price increases weren't modest. Stocks in Nippon Steel Corp., Japan's largest steelmaker with whom Brazil's Vale concluded the benchmark deal, rose by 3.2 percent, and the holding company of JFE Steel Corp., Japan's second-biggest steelmaker, enjoyed a 6.3-percent boost, while Baosteel Group Corp. Ltd., China's top producer, also saw its shares rise by a good chunk.

Given all the hoo-hah during the negotiation period about steel mills trying to resist a catastrophic rise in iron ore prices, why did the market appear to welcome a 65-percent increase?

The explanation most widely given was that the increase was actually a lot lower than anticipated. But looking back at media reports, there were few public predictions above 70 percent. Maybe it was the relief factor—that the uncertainty had been lifted and mills could gear up and plan properly for the increase.

Whatever the reasons, it's a big rise .?.?. and follows increases of 9.5 percent last year, 19 percent in 2006 and 71.5 percent in 2005.

Last year's increase became a sore point for iron ore miners because spot market prices soared—first to double and then around triple the benchmark level—so the iron ore majors were keen to claw back some of that lost ground, as well as negotiate a settlement that is fairer this year as spot prices look likely to remain somewhere around the same high level.

Iron ore suppliers are happy for now, but in the long term the Australians—BHP Billiton and Rio Tinto—are looking to shift away from the tendentious annual negotiations. Rio Tinto is moving some tonnage onto the spot market, while BHP Billiton wants a transparent index to determine appropriate pricing levels.

But the response from the Chinese steel industry, which had expected a big rise but vowed publicly never to accept an increase of that magnitude, has been fairly muted. The bigger mills responded simply by announcing big price hikes in order to pass on higher costs to consumers as promptly as possible. All the signs in the market are that these price rises are being readily accepted.

The Chinese steel market is still in robust shape and the major steelmakers by and large made healthy profits in 2007, so they are hardly in mortal danger. The problems come further down the food chain. Many of the medium-sized mills, and most of the smaller ones, operate with lower margins, producing lower grades of steel that have been exported in huge volumes in recent years.

With a global economic slowdown looming and the Chinese central government cracking down on exports, the overseas market won't be like 2007 again. The smaller mills are much more exposed than the likes of Baosteel or Jiangsu Shagang Group to major raw material cost increases, and are much more reliant on a volatile spot market.

At the end of last year, many smaller mills were put out of action because they could no longer afford iron ore at prices close to $200 a tonne. That pressure might continue this year, with the increase in benchmark costs already spurring Indian suppliers to the spot market to raise their offers again. At the same time, many of the smaller, often highly polluting mills are being chased by China's authorities, who want a more disciplined and consolidated steel sector.

China's National Development and Reform Commission is already getting tough, ordering inspections as well as punitive action against local authorities that fail to follow closure orders. Progress in this regard was relatively weak last year, but market forces and government pressure might conspire to bring greater pressure this year.

The irony of the 65-percent rise in iron ore costs is that it could end up achieving exactly what the Chinese are looking for greater consolidation of the domestic market, which in turn will benefit the bigger mills.

Maybe this is the reason why China's steel lobby was surprisingly quiet in the aftermath of the iron ore deal, and maybe it's part of the reason why, at least in China, steel companies' shares reacted warmly to the higher prices.

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